Golden Rules of Accounting--The root concept

Golden rules of Accounting—

Journal entries are the recording of transaction in the original book called Journal. Whatever transaction has taken place during an accounting period should be recorded in journal but these transactions are not recorded randomly; Accounts has given some core rules for the recording of transaction, this rule is called Golden rules of Accounting. These rules are the backbone of accounting. No accounting is possible without them. These rules can be imagined as the rule of driving a car before starting a journey, Such as how to change gear, how to apply brake, how to move steering. Like every person who is in the journey and driving a car should know the basic rules of driving similarly, every accounting student should know this rule before starting a long journey of Accounting. So here it is let’s learn it:

In journal entry we record any transaction in this wayà

Bla-bla-bla A/c           dr

    To blab la bla a/c

Means there are two items in any transaction, and each item is an account, thus, if numbers of  transaction has been taken place in an accounting period, there would be numbers of accounts-- Golden rules say that all these accounts comes under three main division, they are as follows:

·        Personal Account.

·        Real Account.

·        Nominal Account.

Personal Account—

 The Accounts that relates to persons are called personal account. In doing business, owner deals with lots of persons- they can be living person like Ram, Shyam etc or artificial persons like company, organization or institution. Apart from this there are some deemed personal account like-outstanding expenses, prepaid expenses, etc.

Now the golden rule of recording transaction of personal account is:

                           Debit the receiver of the benefit.

                           Credit the giver of the benefit.

Real Account—

The accounts that relates to asset are called Real account. Asset can be of tangible (that can be touched) like-furniture, cash, stock, building etc, and intangible (that can’t be seen and touched) like patent, trade mark, goodwill.

Golden rules regarding real account is:

                            Debit what comes in,

                            Credit what goes out.

Nominal Account—

Accounts that relate with income and expense of business are called Nominal account like purchase, sales, wages, rent etc.

Golden rules regarding nominal account is:

                       All expenses are debit.

                       All incomes are credit.

The above rules can be understood with the help of following illustration:

Suppose, purchased goods on cash for Rs 2000.

Here purchase is an expense and rule says that all the expense should be debit. So, purchase should be debit. “Cash” is a real account and the rules of real account says that debit what comes in and credit what goes out. Here cash goes out of the business because we are purchase goods by giving cash to the supplier. Thus “cash” should be credit. Now, the exact entry should be:

Purchase a/c       dr 2000

   To cash a/c                   2000

(Being goods purchased on cash)

{The perfect format of journal entry will be mentioned later, now my intention is to make you understand the root concept behind any entry}

“Purchased goods from Ram on credit for Rs 2000”

Here again purchase is an expenses and it should be debited according to the rule of nominal account. Now purchase is made on credit and Ram is a personal account as he is person. We know the rules of personal account that debit the receiver of benefit and credit the giver of the benefit. Here Ram is the giver of the benefit to us because he has given us goods on credit so he should be credited. Thus the entry for this transaction will be:

Purchase a/c      dr 2000

 To Ram a/c                   2000

(Being goods purchased on credit)

If the name Ram was be absent in transaction above we would write “Creditors” instead of Ram.

Now look again, “purchase machinery for Rs 25000”

Here we should not confuse it with ‘purchased goods’ which is an expense because goods are used in day to day activities of business where as machinery is an asset which is intended to give profits in the future periods also.

Now come to the point, machinery is an asset which is the part of real account and the rules of real account is debit what comes in, credit what goes out. Here machinery is being coming in the business so it should be debited. On the other hand cash is going out from business so it must be credited. Thus, the exact entry is:

Machinery a/c          dr 25000

  To cash a/c                               25000.

(Being machinery purchased on cash)

{Here student should note that debtor is a current asset but they are the part of personal account not real account because debtors are the person either living or artificial. Assets other than person are the part of real account.}

“Started business with cash 5000”

Here the journal entry would be:

Cash a/c                     dr 5000

 To capital a/c                    5000

(Being introduce cash into the business as capital)

Here what happened is cash is a real account so it must be debited as it is coming in. capital is a personal account and the rule is “credit the giver of the benefit” here the owner is giving benefit and owner is represented as *capital here so capital is credited.

*{In accounting owner all the works- purchase, sales, etc are done by the business alone not by the owner he is doing on the behalf of business –recall—entity concept only owner is represented in two circumstances—first, in capital –that is, when he is introducing capital in the business and second, in drawing-that is when he is drawing from the business}.

 So this how we come to the end of another important topic. The journal entries above were only to show you the way golden rules of accounting works. The detail about it will be explained in my upcoming post.